Time for GE to Spin Off Its Capital Unit

Jul.20.10 | About: General Electric (GE)

General Electric (NYSE:GE) is the only stock in the Dow Jones Industrial average that was in the index at its inception in 1896. However, through the years General Electric has changed its stripes many times. The most recent ‘stripe change’ involves its evolution from a manufacturing conglomerate during Jack Welch’s tenure to an entity resembling a financial institution.

In 1999 Fortune magazine named Jack Welch the “Manager of the Century”. I am going to proclaim something that some may think as heresy, but I think Jack Welch may be one of the most overrated CEOs in the history of the United States.

I admit Jack was a good manager. However, I think his capabilities were vastly overrated. Much of his success has to do with being in the right place at the right time. In a way, his legacy is similar to Alan Greenspan’s. Both were the beneficiary of a secular decline in interest rates and a credit bubble. There is an old saying that, “Time heals all wounds.” I think you could also say, “Time reveals the truth.” I think it is obvious that much of our problems in our economy and the problems at GE result from Greenspan’s easy monetary policies.

Jack Welch served as CEO of General Electric from 1981 until 2001. During this 20 year period, earnings per share increased at an annualized rate of 51.2%. The stock price of GE increased at an astounding annualized rate of 119.2%. (On a split adjusted basis, the stock price went from 1.20 at the end of 1981 to 40.08 at the end of 2001.) Some of these fantastic returns were the result of Jack doing a good job of cutting costs and following his mantra of ‘If we can’t be number one or number two in a business, we should sell it.” However, I argue that most of his performance was being in the right place at the right time.

There are two reasons why the stock and business performed so well during Welch’s 20 year tenure as CEO. In terms of the stock, the multiple assigned to GE’s earnings expanded significantly. At the end of 1981, GE’s stock sold at a Price/Earnings ratio of 8.1. At the end of 2001, GE’s stock sold at a P/E ratio of 28.4. This three and one-half increase in the multiple assigned to GE’s stock greatly contributed to GE’s stellar stock performance during Welch’s tenure.

A second factor contributing to GE’s success was the growth in the GE Capital unit. This unit grew on the back of the credit bubble that ran through the end of 2007 and a historic drop in interest rates. From December 31, 1981 to December 31, 2001, the 10 year Treasury Bond yield dropped from 13.98% to 5.07%. This is the biggest 20 year drop in interest rates in our country’s history.

The earliest segment data I can find on GE Capital is from 1989. In 1989, GE Capital was 18.1% of General Electric’s operating earnings. In 2001, the year Welch retired, GE Capital was 34.0% of the GE’s operating earnings. In 2007, at the peak of the credit bubble, GE capital was 49.2% of GE’s operating earnings. After the credit bubble burst, from 2007 to 2009, operating earnings within GE capital declined by 87.2%. Earnings per share for all of General Electric fell 54.1% over the same time period.

GE is slowly trying ‘change its stripes’ again as it tries to transform itself from a financial services company to a company that is focused more on the healthcare and alternative energy. (How many times a week do you see an ‘infomercial’ about GE that claims ‘Imagination at Work’? What a great way to waste shareholder money!) I am not sure they can make the transformation. I think the best thing management at General Electric could do is spin-off its financial segment. This would create a ‘bad’ GE and a ‘good’ GE. This would be in the best interest of shareholders. My guess is they will not do a spin-off because it would make ‘their empire’ smaller if it is in two pieces. Hence, if they are not willing to do what is in the best interest of shareholders, I strongly suggest shareholders sell GE.

Disclosure: Two clients of Granite Value Capital, who have a very low cost basis, own a small position in General Electric.